THE IMPACT OF PAYING INTEREST ON RESERVES IN THE PRESENCE OF GOVERNMENT DEFICIT FINANCING

This paper reexamines the impact that paying interest on reserves has on price level indeterminacy, volatility, and economic well-being. Unlike the previous literature, this model includes an after-tax deficit financed by assets (bonds and reserves) whose returns are linked. I show that the number of steady-state equilibria and the corresponding level of indeterminacy are equal to, or greater than, those arising in the no-interest economy. When the level of indeterminacy is the same, the economic volatility is reduced by paying interest. However, greater indeterminacy in the interest economy results in greater volatility. However, greater indeterminacy reserves call enhance welfare.